Question

Explain the two basic risks that are inherent in developing any financial portfolio. Be sure to identify which risks are reduced with the creation of a portfolio, and the factors that affect the types of risk that are managed within the portfolio. As part of your answer, be sure to answer the question- how many securities does it take to effectively diversify a portfolio- the answer of which is to be found in Chapter 5 reading in figure 5.3.

Since mutual funds are collections of securities that are essentially a managed portfolio, the same rules of risk and return apply. From your readings on the Efficient Market Hypothesis, do you believe that mutual funds outperform the market as a whole? Explain.

Answer 1

Question 1:

The two risks that are inherent are:

1. Systematic risk or market risk

2. Unsystematic risk or sector specific risk

When you create a portfolio, we can reduce unsystematic risk or sector specific risk because of diversification. So, in a portfolio if we choose dividend stocks from each industry or sector, the sector specific risk gets nullified and hence it is possible to reduce unsystematic risk through diversification. However, systematic risk cannot be reduced through diversification.

Question 2:

We cannot be sure if the mutual funds portfolio outperforms the market index. In mutual funds, it depends on the stock selection. Since the market as a whole contains all listed securities, the risk is slightly lower than the mutual fund portfolio. So, if the fund manager is good in selecting those stocks in the portfolio which perform well and eliminate those which are drag, then the fund will beat the index or market as whole. If the fund manager makes an error in selection, the portfolio fails to beat the market. So, the outperformance depends on the ability of the fund manager.